Important Announcement

Trade of the Week - Put Credit Spread (1/12/2010)

I'm putting on another put credit spread. This may seem repetitious, but as I've said recently, you can't argue with the trend.

Put credit spread on the DIA

Sell DIA 104/102 put spread
1. Exit if I can lock in 80% of my initial credit (i.e. $.10)
2. Exit if cost to close >= twice initial credit (i.e. $.95)
3. Exit if within 4-7 days of expiration
4. Watch the 30 day MA for possible early exit
Credit $.47

This is a $2 wide credit spread or vertical spread strategy on the DIA. As such, it will follow the trading rules that are part of my trading plan for this strategy.

Why this strategy?

I love this strategy when the market is moving in a definite direction. As I mentioned in my last trade setup, this strategy benefits in several ways when the market is moving up. It benefits in movement away from my short strike, it benefits in decreasing volatility and it benefits in the passage of time.

I continue to be bullish as long as the charts indicate this is called for. In the above chart, DIA has clearly broken out of a horizontal resistance and that should act as support. In addition, the 30 day and 50 day moving averages are pointing up and may act as support levels as well.

I continue to use ETFs, and in particular the broad market ETFs for a number of reasons i outline here. Because the DIA follows the Dow Jones 30, it is one of the market indicators, although not as broad in coverage as either the SPY (S&P 500) or the IWM (Russell 2000).

I also like the DIA because the price (just over $100) makes the options priced fairly decently. In this increasingly low volatility environment, it's harder then it has been for over a year to get good prices on options.

Choosing the right strike prices

My trading plan for the credit spread indicates choosing a strike month with 20-40 days until expiration, which will be the February options. It also specifies choosing a short strike with a probability of expiring in the money of 30-35%. This will yield a trade with an approximate probability of success of 65-70%.

When I first started looking at this  trade, the 103 strike fit that requirement. However the market was on the move and by the time I investigated and set the trade up, the 103 strike fell at one point below 30%. I ended up selecting the 104 strike even though it was slightly higher than I prefer.

Credit spread strike selection

Since this is a $2 spread, I can select my long strike easily once I have the short strike chosen. I ended up with a February $104/102 spread for $.47.

Position sizing

My purpose in going through this position sizing exercise is to ensure that no trade exposes me to excessive risk to my portfolio. Additionally, it helps me consistently allocate funds. Since I never know which trades will be successful when I put them on, it would be a shame if my successful trades were on trades that I under allocated for. Conversely, it is painful when one of my losing trades is on one where I over allocated. This makes for a very inconsistent equity curve.

With that... I'll get right to position sizing of this trade.

I have been risking 2% of my portfolio on each trade. With a $20,000 portfolio, that's a $400 trade risk. That's the first half of the equation.

The other half is a little more challenging and is predicated on my exit plan. Let's break down the trade I"m looking at.

With a $2 wide spread, I have $2 in risk in this trade. Since I'm receiving a credit of $.47, my remaining risk (from my own portfolio) is $1.53. This represents my maximum loss in the trade. 

If I employ an early exit strategy that further limits my risk then this risk amount is reduced. For the credit spread strategy, my exit rules call for limiting my risk to an amount equal to the credit I receive. That means if I might receive credit of $.47 so I would exit when I stood to lose $.47. This is the other half of the equation.

With that, the formula is simply $400/$47 or 8.5. That means I'll only take 8 contracts. Selling 8 contracts at $.47 yields a max gain of $376. Since my broker doesn't necessarily know of my plan to exit early, they will hold the maximum risk as my margin. That means with my 8 contracts, $1224 of my own money in margin. That means my ROI is $376/$1224 is 30.7%.

Exit plan

I've already mentioned one of my exit strategies. That is to close when I stand to lose an amount equal to the credit I received. That means I will need to close the trade when the cost to close equals $.94.

My other exit per my trading plan for credit spreads is to exit when I can lock in 80% of my initial credit. This actually means I'll close the trade when the cost to close is 20% of the initial credit. That means I will close when I can do so for about $.10, which leaves me with $.37 in net profit.

Finally, since my decision to enter is based on some technical analysis, it's worth considering an exit based on technical reasons. There is a support level at $105 that was formerly a resistance level. However, I'm looking to the 30 day moving average as a support level to consider. As time progresses and the moving average continues higher, I'll be less concerned about this and may look to the 50 day moving average as an exit indicator.

To summarize my exits... I will exit under the following conditions.

  1. I will exit when I can do so for $.10, which allows me to lock in 80% of the credit or $.37.
  2. I will exit when the cost to close is $.94, which represents my plan to limit my loss to an amount equal to the credit received.
  3. I will exit when approximately 4-5 days of expiration.
  4. I'll consider exiting if I see a break of support on the 30 day moving average.

It always helps to have a mechanical means of enforcing my rules. On the Thinkorswim platform, I can set up a 'one cancels other' order. This will help ensure that the first two exit rules get executed regardless of how I feel at the moment or even if I'm not monitoring the trade at the moment.

credit spread exit orders

In this example, I have one order that is a limit order to close when the cost to close is $.10. The other order is a stop order that triggers when the price of the spread reaches $.95.

Portfolio Impact

Since no trade exists in my portfolio independent of the other trades, it's important to look at the overall impact of this credit spread trade on the portfolio. 

Credit spread portfolio impact

Since this is a bullish trade, it's expected that I'd be adding positive delta. Since I'm selling a spread, it's also expected I'd be adding positive theta. The net effect is that I now have more positive delta and more positive theta (or less negative theta). I still have the remainder of a calendar spread that is adding a fair amount of negative theta. 

I now have a portfolio that is pretty bullish and that means I have more exposure in the event the market sells off. This doesn't have to be a bad thing, but it's important to know.

In the future, I may want to look into the possibility of adding negative delta with more positive theta. That would be a call credit spread. As we see ongoing move up of DIA, adding call spreads may be worth considering.

Update 1/19/2010

The market has langusihed somewhat over the last week. That's not necessarily a bad thing in light of the credit spread trade I have on.

In spite of the selling that took place on Friday, this trade is still in profit. February has now become the front month options so we should start to see time erosion pick up even more. I notice that that 50 day MA is close to breaking 104. With both the 30 day MA and the 50 day MA above 104, I have two potential support levels above my short 104 strike. That should help improve the odds of success on this trade.

For now, it's too early to take any action based on the rules I've established. I'll continue to monitor this trade and take action as necessary per my rules.

1/23/2010 (closing summary)

With the selling over the last several days, my stop loss order has been triggered.

To be honest, as I thought about my first three trades of the year given my new determination to follow the trend, I felt like I was being punished for making that decision. After all, I was right the about a pullback coming but wrong about the timeframe. 

Was I wrong about my decision? If I step back and look at this objectivly, I can see that it's unfortunate that I waited so long to stick with the trend. I also cant predict which trades will lose money, which is why money management is so important. So, I remain committed to trading what I see, which means if the trend changes to a channelling market or a bearish trend I need to trade appropriately.

Could I do anything differently? If I'm to hold my new resolution, no. Is there room for compromise? Maybe. I had talked about selling some call credit spreads on these trades but hadn't gotten to doing so. That would be one way to hedge some of the risk and balance out my stong bullish bias. Unfortunately, I didn't act soon enough. 

Credit spread exit

Ok, so I want to finish with an analysis of the trade. My stop triggered at $.98, which means I lost $.41 per contract times 8 contracts or about $328. That's about 1.6% of my portfolio. By itself, that's not too bad. However, I lost 1.6% on this credit spread, 2% on my SPY credit spread and .6% on my EWZ credit spread for a total of 3.2%. All things considered it could be worse.

I am now out of the market with no real bias.

Rule # 1 - Don't lose money.
Rule # 2 - Never forget Rule #1  (Warren Buffet)

Note: This trade discussion is for educational purposes only. I am NOT making any recommendations on the trade or the underlying stock or ETF. If you decide to follow this trade, please do so in a paper trading account. Trading options involves risk and some options strategies can result in losing more than the original amount invested.

thinkorswim, Division of TD Ameritrade, Inc. and Success With Options are separate, unaffiliated companies and are not responsible for each other's services and products.

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